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E(RM) - Rf security market line (SML)

A positively sloped straight line displaying the relationship between expected return and beta.

The term E(RM) - Rf is often called the market risk premium because it is the risk premium on a market portfolio.

The Capital Asset Pricing Model To finish up, if we let ER) and (3; stand for the expected return and beta, respectively, on any asset in the market, then we know that asset must plot on the SML. As a result, we know that its reward-to-risk ratio is the same as the overall market's:

market risk premium

The slope of the SML, the difference between the expected return on a market portfolio and the risk-free rate.

If we rearrange this, then we can write the equation for the SML as:

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

13. Return, Risk, and the Security Market Line

© The McGraw-Hill Companies, 2002

PART FIVE Risk and Return capital asset pricing model (CAPM)

The equation of the SML showing the relationship between expected return and beta.

This result is the famous capital asset pricing model (CAPM).3

What the CAPM shows is that the expected return for a particular asset depends on three things:

1. The pure time value of money. As measured by the risk-free rate, Rf, this is the reward for merely waiting for your money, without taking any risk.

2. The reward for bearing systematic risk. As measured by the market risk premium, E(Rm) - Rf, this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting.

3. The amount of systematic risk. As measured by (3,-, this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset.

By the way, the CAPM works for portfolios of assets just as it does for individual assets. In an earlier section, we saw how to calculate a portfolio's (3. To find the expected return on a portfolio, we simply use this (3 in the CAPM equation.

Figure 13.4 summarizes our discussion of the SML and the CAPM. As before, we plot expected return against beta. Now we recognize that, based on the CAPM, the slope of the SML is equal to the market risk premium, E(RM) - Rf.

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